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Red Herrings, Margin Calls And Heart Attacks

Most recent commentary we have read suggests that January’s turmoil can be blamed on either the slowdown in China or the fear of an impending US recession. But let us suggest an alternative: these are red herrings which only distract from the real analytical challenges faced by investors.

First, on China: who did not expect a slowdown? And aside from the small minority of foreign investors who buy renminbi denominated assets, who really cares whether a dollar gets you RMB6.3 or RMB6.6, or for that matter, even RMB7.2. In recent years euroland and Japan have seen far more dramatic currency moves and global financial markets barely raised an eyelid.

As for the US, a recession in the world’s biggest economy would undeniably be very bad news for global risk assets. However, the US increasingly looks like every other developed economy with weak industrial production, weak manufacturing, weak trade, solid housing, decent domestic consumption and decent domestic service industry growth. And frankly, no data published in the past three months has fundamentally changed that impression (this picture may not be stable, but that discussion is for another day).

Identifying the curve-balls

In fact, over the past three months, nothing that “surprising” has happened on a macro, or policy, level among the world’s two economic locomotives. Yet against a background devoid of genuine “surprises”, financial markets have acted very sick. Rather than from policymakers or economies, in recent months the curve-balls have come from financial markets. As such, this sell-off is different from late 2012 (triggered by the eurozone crisis and the US budget fight), or the “taper tantrum” in the summer of 2013 (triggered by the Federal Reserve’s change of policy) or even last August’s pullback (triggered by China changing its renminbi policy). And among the many “curve-balls” investors have lately had to deal with, the following stand out:

Curve-ball #1: an absolute collapse in oil prices; crude prices have fallen -70% over the past 18 months. This is unprecedented in the modern era.

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Curve-ball #2: Amidst a collapse in oil prices, banks almost everywhere have in the past six months actually managed to underperform energy stocks!

Worse yet, a number of banks are now either taking out lows they made in 2009 (Standard Chartered), or getting close (Santander, Deutsche Bank). So in spite of seven years of unprecedented liquidity injections by central banks, negative short rates and steep yield curves on which to make free money, a number of banks are right back to crisis era valuations.

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Curve-ball #3: The correlation between oil prices and global equity markets has, over recent months, moved from negative to almost perfectly positive.

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Even markets like India or Korea, that have traditionally soared on the back of lower oil and commodity prices (as they should since collapsing commodity prices correspond to a dramatic improvement in their terms of trade) have lately become positively correlated to oil prices.

So how does this whole add up into something even mildly coherent?

Together these curve-balls leave most investors with an uncomfortable feeling. For a start, it is disquieting when markets do not behave “as they should” and the positive correlation between oil and equity prices is certainly odd. Second, alarm bells ring for most investors when, for no obvious reason, banks underperform massively. Indeed, the highly leveraged world that we inhabit can be compared to an overweight and under-strength body in which the banks are the heart that allows liquidity to flow through the system, thereby keeping the overweight body moving. But this also means that any potential sign of a heart attack has to be taken very seriously.

And this brings us to the quandary at hand; namely is the -70% collapse in oil prices (and other commodities) enough to trigger a heart attack?  Having been long-standing commodity bears, this is a question we have pondered for a while, only to repeatedly conclude that, by and large, the direct exposure of banks to the broader commodity sector was manageable. But clearly, the behavior of markets in recent weeks implies that this nonchalance may be misplaced and we have been looking in the wrong place to understand banks’ commodity exposures. Perhaps what matters is not the banks’ direct loan exposure to the sector, but instead their exposure to commodity related derivatives?

According to the Bank for International Settlements, the notional size of the commodity-related over the counter derivatives market is US$1.6-US$2.2trn. Throw in listed derivatives and it would not be a stretch to think that commodities represent at least US$4trn of a global derivatives market worth anywhere up to US$700trn. Possibly, a lot more…

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This brings us to Warren Buffett’s quip on derivatives being “financial weapons of mass destruction”; which most of the time, they are not. Because inherently in a derivative contract, someone is long and someone is short, and the enormous amounts mentioned above net out. That is, until someone, or several people in the chain, go under. In which case the repercussion effect across the chain can be catastrophic.

Take the 2008-09 crisis as an example: fundamentally, around US$500bn worth of losses on US mortgages ended up, through the magnifying effects of derivatives markets, wiping out US$28trn from global equity markets and US$7trn from global GDP.

This unfortunate precedent raises the question of whether we could see a 2008-like crisis, with the catalyst this time around being the bankruptcy of commodity companies which cannot fulfill their derivatives promises, instead of the default of mortgage bonds. Is this what the massive underperformance of banks is pointing towards?

The chief executive of the world’s biggest money manager recently warned that up to 300 oil companies will default in the coming year. And even if only a fraction of that number actually go under, can we be sure this won’t cause dislocation in the broader derivative chain? This question is relevant to market behavior of recent weeks since the impression has been of a big player who is “sick” and “throwing up” positions (see Who Is The Marginal Buyer?). But while selling by oil-based sovereign wealth funds could explain emerging markets’ underperformance, it cannot explain the relative underperformance of banks pretty much everywhere. Looking at market behavior, it is hard to escape the conclusion that someone is getting one heck of a margin call. Back in 2008, the “margin call” was on everything housing-related—this time around, the margin call is likely to be on everything related to commodities.

But this “margin call” also makes a policy response very complicated. Indeed, in 2008, policymakers could say: “We must intervene to save the banks, and save your mortgage. If we don’t, millions will be left  repossessed and homeless”. Politically, the act of saving bankers went down like a lead balloon, but a lot of people were still secretly glad to have government support. Contrast that with today: if saving bankers was unpopular, how will saving commodity brokers and traders go down? Which politician wants to stand up in parliament and make an impassioned speech on how we need to save Noble Group, Marathon Oil, or Fortescue?

So here we are, with a panic unwinding on derivative commodity positions and the looming fear that a break in the chain would clean out certain banks. And it is such fears that usually cause banks to lend less to each other, thereby pushing up the cost of capital for everyone and triggering “irrational correlations” between unrelated asset prices (such as oil and equities).

And if the above daisy chain is correct, this means that we are left with four possible scenarios:

Scenario #1: The fear of bankruptcies in the commodity space is overblown—at this juncture, this looks more like a “Hail Mary” than a proper investment strategy.

Scenario #2: Bankruptcies indeed unfold but the broader system is sufficiently cashed up to withstand the resulting short-term shocks—up until a few weeks ago, this was most likely the “consensus” opinion. But recent market moves are starting to make this position more tenuous. 

Scenario #3: Bankruptcies will soon unfold in the commodity space but, as this happens policymakers get in front of the curve and massively ease monetary and fiscal policies—in this scenario, buying gold, high yield debt and emerging markets probably makes good sense.

Scenario #4: Bankruptcies unfold and policymakers can do very little about it—In this scenario investors should just own JGBs and treasuries. Perhaps canned goods and shotguns for diversification…

In recent weeks, markets seem to have pushed up the odds of scenarios three and four. Which in turn raises the question of what policymakers can do to ease the situation? And how quickly can they do it?

On the latter question, one key concern has to be that the US is in an election year, as was the case during the 2008 campaign.  Should the need arise any dramatic economic and financial decision-making will be more challenging and convoluted. In a lame-duck year, important decisions are simply more likely to be postponed or fall through the cracks. The fact that there is no incumbent running lengthens the odds of scenario three, and shortens those of scenario four.

Still, assuming that Washington can get its act together (hope springs eternal), what does “policymakers getting in front of the curve” really mean? It could mean that banks are pressured to raise more equity capital, providing them with more of a cushion should there be a repeat of the derivative market dislocation seen in 2008. Clearly, this is not happening today. Banks are seldom keen to issue capital at or below book value, but perhaps they fear there would not be enough takers for a rights issue. Unlike in 2008 it seems unlikely that the sovereign wealth funds of oil producing countries will be lining up to write checks to value-destroying banks of the big western economies.

This point brings us back to the quandary faced by global markets: with ageing baby-boomers slowly divesting their equity holdings across the Western World, with millennials and Generation-Xers scrounging every penny in order to get, or move ahead, on overvalued property ladders, with foreign sovereign wealth funds no longer rolling in cash, and with corporates no longer buying back their stock at the “wrong price” (now that they can no longer borrow at the “wrong price”), who is to be the next marginal buyer of equities?

The answer has to be that either central banks must buy stocks directly (as the Bank of Japan and Swiss National Bank are doing), or they will have to jump-start animal spirits among either corporates or individuals such that they buy equities. Arguably, the simplest way to do the latter will be to mend the broken high-yield bond market.

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However, this will likely take more than just soothing words. Indeed, the main reason for the sharp widening of spreads has not been soaring bankruptcies, but the fact that the US$1.2trn high yield market has in recent months had to deal with some US$50bn of redemptions. And one reason for investors throwing in the towel is the fear that the high-yield bond market will soon be swamped with the paper of “fallen angels”—former investment grade issuers, most frequently in the commodity sector, whose debt faces downgrade by Fitch, S&P and Moody’s. And in the circular world in which we inhabit, the rise in corporate bond yields affects equity markets in one of two ways:

  • First, a higher cost of capital places a significant check on share-buyback activity and the ability of firms to use financial engineering in order to meet earnings expectations (also known as leveraging the balance sheet in order to hit earnings-per-share targets).
  • Second, the higher that corporate bond yields rise, the more attractive it is for the marginal dollar to flow into corporate bonds rather than equities—for example, today, why buy the equity of marginal oil exploration and production companies in the US when energy bonds are yielding 18%?

The obvious way for policymakers to stabilize the system would be to spend a few hundred billion dollars buying back high-yield corporate debt. But can the Fed undertake such an operation at current levels? Or will it take more of a crisis, and a few big bankruptcies, for such a course to be charted? And, if the latter is the case, will the “necessary” bankruptcies trigger a forced unwinding across financial markets? And is this not what the markets are dealing with today, rather than any re-adjustments because China’s currency has moved from RBM6.3 to the dollar to RMB6.6?


  • >Anonymous



    On the point, many thanks for your thoughts.

  • >Anonymous



    Dear Louis,

    This is a very interesting article. The conclusion is also a good and obvious one, if far-fetched. But the body of the article suggests that the author has made up his mind that a recession is looming, based on his view of the Wiksellian mis-pricing of money, and that he is looking for evidence to corroborate his theory.

    What is equally compelling is the fact that share price pressures are the result of yield curves flattening and that this harms the earnings and share prices of banks. No more, no less.

    It would be useful if Anatole responded to the article, which he no doubt will.

    Kind regards,

    • Dear Peter,

      I dont think i suggest that a recession is looming? In fact, the only part in which i mention a recession is to dismiss the talk of a US recession as a red herring.

      I would go one step further: all of us in our carreers have been trained to look for recessions and see these as a CATALYST for poor market performance. But what if, in this modern and hyper-leveraged, world of ours, it actually was the other way around: instead of going from recession to bad markets, the move is actually from market crisis and into recession?

      That was the scheme for most of the pre WW2 period and, in this deflationary world of ours, could well be the pattern again. Of course, your typical economist will not go down this path of thinking (because that would make him obsolete!), nor will your believer in 'efficient market theory" (if there are still any of those around?

      On your point on me searching for confirmation of a Wicksellian theory, i must admit that i am very confused as to how and where you get that from in this piece, or frankly in ANY piece that i have EVER written as, for the life of me, i can't think of a single piece I have written in which I go into Wicksell? And definetly not in this piece.

      the fact that banks are getting crushed by flattening yield curves is a given - but that still begs the question as to WHY, at this point in the cycle, yield curves are flattening massively everywhere. in fact, why is the ten year - 2 year difference in the US back to record lows after seven years of ZIRP?

      I have no doubt that Anatole will continue presenting his outlook but if you want an update on what Anatole is thinking, it is pretty clearly presented in the January and February Monthlies, as well as his piece published last week "Is Wall Street In a Bear Market?". From my latest conversations with him, I don't think his thinking has changed very much.

      Of course, we discussed this latest piece and I think he was intrigued by the theory but he remains hopeful that the transfer from oil producer into the oil consumers' pockets will prove to be a much more economically powerful force than the short term hole triggered by the capital destruction in the commodity space.

      FWIW, i think that, long term, Anatole is undeniably right (much better to have money in the Western/Asian consumer's pockets than in Saudia Arabia's, Russia's, or Venezuela's governments pockets...) but near term, the markets' recent behavior does raise the question of whether we could have a 2008 like event whereby losses that would seem 'manageable' for the overall system become magnified through messy unwinds, over-levered derivative products, and hits on fragile bank balance sheets.

      Which brings me to a side point: today, EVERYONE and their dog is looking for China to have a banking crisis. But meanwhile, there seems to be a genuine banking crisis unfolding in Italy... and yet no-one cares? however, If (obviously it is a massive if), banks do start to take hits on commodity related derivatives, are European banks, and European economies, strong enough to withstand another shock after seven years in the doldrums? At this point, should this not be our number 1 concern,

      Thanks for the feedback

      Yours truly


  • >Anonymous



    Just curious - how much has been invested in oil and oil-related industries in the past decade? - In US as well as elsewhere? how does it compare to the global capex cycle in magnitude? - As we speak about misallocation of resouces under prolonged zero-rate regime, just wondering if we can quantify the "misallocation" towards this broad sector.